UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended SEPTEMBER 30, 2007

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________________to __________________

 

Commission File Number: 0-10956

 

 

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Act).

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

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TABLE OF CONTENTS

 

 

 

 

 

 

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

(Unaudited)

 

 

 

See accompanying Notes to Interim Consolidated Financial Statements.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

(Unaudited)

 

 

 

See accompanying Notes to Interim Consolidated Financial Statements.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF INCOME

 

(Unaudited)

 

All balances presented below, with the exception of net investment income, realized investment gains (losses) and income tax expense (benefit), are the result of related party transactions with Employers Mutual.

 

 

 

See accompanying Notes to Interim Consolidated Financial Statements.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

(Unaudited)

 

 

 

See accompanying Notes to Interim Consolidated Financial Statements.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(Unaudited)

 

 

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED

 

(Unaudited)

 

 

 

See accompanying Notes to Interim Consolidated Financial Statements.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

 

(Unaudited)

 

 

The accompanying unaudited consolidated financial statements have been prepared on the basis of U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim financial statements have been included. The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year.

 

The consolidated balance sheet at December 31, 2006 has been derived from the audited financial statements at that date, but does not include all of the information and notes required by GAAP for complete financial statements.

 

Certain amounts previously reported in prior years’ consolidated financial statements have been reclassified to conform to current year presentation.

 

In reading these financial statements, reference should be made to the Company’s 2006 Form 10-K or the 2006 Annual Report to Shareholders for more detailed footnote information.

 

 

In February 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 155, “Accounting for Certain Hybrid Financial Instruments” – an Amendment of FASB Statement Nos. 133 and 140. SFAS 155 simplifies the accounting for certain hybrid financial instruments by permitting fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and eliminates a restriction on passive derivative instruments that a qualifying special-purpose entity may hold. The Company adopted SFAS 155 effective January 1, 2007. Adoption of this statement had no effect on the operating results of the Company.

 

In June 2006, the FASB issued Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”) to clarify the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS 109 “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance for de-recognition of tax positions, financial statement classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company adopted FIN 48 effective January 1, 2007. Adoption of FIN 48 had no effect on the operating results of the Company, as an assessment of the Company’s tax positions indicated no uncertainties that would warrant different recognition and valuation from that applied in the Company’s tax returns.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Management is currently evaluating what impact, if any, this statement will have on the Company’s financial statements.

 

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            In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Company’s financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity investments currently classified as either available-for-sale or held-to-maturity, and report the unrealized gains and losses from these investments in earnings going forward. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the alternatives permitted by this statement and the impact those alternatives would have on its financial statements.

 

 

The effect of reinsurance on premiums written and earned, and losses and settlement expenses incurred, for the three months and nine months ended September 30, 2007 and 2006 is presented below.

 

 

 

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            For 2006, premiums written assumed from affiliates and net premiums written reflect an adjustment for the reduction in Employers Mutual’s participation in the Mutual Reinsurance Bureau (MRB) pool. The board of directors of the MRB pool approved the admission of Kentucky Farm Bureau Mutual Insurance Company and Country Mutual Insurance Company as new assuming companies to the pool effective January 1, 2006. This reduced Employers Mutual’s participation in the pool from a one-third share to an approximate one-fifth share (Country Mutual is only assuming property exposures). The premiums written assumed from affiliates and net premiums written amounts for the nine months ended September 30, 2006 include a negative $3,440,024 portfolio adjustment related to this change in participation.

 

 

The Company has no stock-based compensation plans of its own; however, Employers Mutual has several stock plans which utilize the common stock of the Company. Employers Mutual can provide the common stock required under its plans by: 1) using shares of common stock that it currently owns; 2) purchasing common stock on the open market; or 3) directly purchasing common stock from the Company at the current fair value. Employers Mutual has historically purchased common stock from the Company for use in its stock incentive plans.

 

Employers Mutual maintains two separate incentive stock option plans for the benefit of officers and key employees of Employers Mutual and its subsidiaries and affiliates. A total of 1,000,000 shares were reserved for issuance under the 1993 Employers Mutual Casualty Company Incentive Stock Option Plan (1993 Plan), and a total of 1,500,000 shares of the Company’s common stock were reserved for the 2003 Employers Mutual Casualty Company Incentive Stock Option Plan (2003 Plan).

 

The 1993 Plan and the 2003 Plan provide for awards of incentive stock options and both plans have a ten year time limit for granting options. Options can no longer be granted under the 1993 Plan and no additional options will be granted under the 2003 Plan as Employers Mutual recently implemented a new stock incentive plan. Options granted under the 1993 Plan and 2003 Plan have vesting periods of two, three, four or five years with options becoming exercisable in equal annual cumulative increments. Option prices cannot be less than the fair value of the common stock on the date of grant.

 

On June 1, 2007, the Company registered 2,000,000 shares for use in the 2007 Employers Mutual Casualty Company Stock Incentive Plan (2007 Plan). The 2007 Plan provides for the awarding of performance shares, performance units, and other stock-based awards, in addition to qualified (incentive) and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units. The 2007 Plan provides for a ten year time limit for granting awards. Officers, key employees and non-employee directors of Employers Mutual and its subsidiaries and affiliates, as well as certain agents, may participate in the Plan.

 

The Senior Executive Compensation and Stock Option Committee (the “Committee”) of Employers Mutual’s Board of Directors (the “Board”) grants the awards and is the administrator of the plans. The Company’s Compensation Committee must consider and approve all awards granted to the Company’s executive officers.

 

The Company recognized compensation expense of $46,243 and $42,362 for the three months and $154,698 and $139,733 for the nine months (gross and net of tax) ended September 30, 2007 and 2006, respectively, related to the 2003 Plan. The Company recognized compensation expense of $6,997 ($4,548 net of tax) and negative compensation expense of $89,550 ($58,208 net of tax) during the three months and nine months ended September 30, 2007, respectively, related to a stock appreciation rights agreement that is being accounted for as a liability-classified award. During the first nine months of 2007, 117,250 options were granted under the 2003 Plan to eligible participants at a price of $25.455 and 29,746 options were exercised under the plans at prices ranging from $9.25 to $24.60.

 

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5.    SEGMENT INFORMATION

 

The Company’s operations consist of a property and casualty insurance segment and a reinsurance segment. The property and casualty insurance segment writes both commercial and personal lines of insurance, with a focus on medium-sized commercial accounts. The reinsurance segment provides reinsurance for other insurers and reinsurers. The segments are managed separately due to differences in the insurance products sold and the business environment in which they operate.

 

 

 

 

 

 

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            The following table displays the net premiums earned of the property and casualty insurance segment and the reinsurance segment for the three months and nine months ended September 30, 2007 and 2006, by line of business.

 

 

 

 

The actual income tax expense for the three months and nine months ended September 30, 2007 and 2006 differed from the “expected” income tax expense for those periods (computed by applying the United States federal corporate tax rate of 35 percent to income before income tax expense) primarily due to tax-exempt interest income.

 

Effective January 1, 2007, the Company adopted FIN 48 “Accounting for Uncertainty in Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance for de-recognition of tax positions, financial statement classification, interest and penalties, accounting in interim periods, disclosure, and transition. Adoption of this interpretation had no effect on the operating results of the Company, as an assessment of the Company’s tax positions indicated no uncertainties that would warrant different recognition and valuation from that applied in the Company’s tax returns.

 

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Management of the Company carefully reviewed all individually significant tax positions during 2007 and concluded that the recording of any obligation related to an uncertain tax position under FIN 48 was not warranted. During the third quarter of 2007, the Company recognized a $34,736 underpayment penalty relating to its December 31, 2006 U.S. federal tax return. The Company did not recognize any interest or other penalties related to U.S. federal or state income taxes during the three months and nine months ended September 30, 2007. It is the Company’s accounting policy to reflect income tax penalties as other expense, and interest as interest expense.

 

The Company files U.S. federal tax returns, along with various states income tax returns. The Company is no longer subject to U.S. federal and state income tax examinations by tax authorities for years before 2004.

 

 

The components of net periodic benefit cost for Employers Mutual’s pension and postretirement benefit plans are as follows:

 

 

 

 

 

Pension expense allocated to the Company amounted to $378,535 and $1,135,605 for the three months and nine months ended September 30, 2007, compared to $657,910 and $1,973,731 for the same periods in 2006.

 

Postretirement benefit expense allocated to the Company amounted to $566,835 and $1,700,511 for the three months and nine months ended September 30, 2007, compared to $664,004 and $1,992,017 for the same periods in 2006.

 

Employers Mutual plans to contribute approximately $3,500,000 to the pension plans and $4,172,000 to the postretirement benefit plans’ VEBA trusts in 2007. As of September 30, 2007, Employers Mutual has not made a contribution to the pension plans and has contributed $3,300,000 to the VEBA trusts.

 

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The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have established reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings.

 

The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of loss reserves eliminated by the purchase of these annuities was $1,779,009 at December 31, 2006. The Company has a contingent liability of $1,779,009 should the issuers of these annuities fail to perform under the terms of the annuity. All of the issuing companies maintain strong financial ratings, therefore the Company believes the likelihood of failure of any of the issuing companies is remote. The Company’s share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries’ aggregate policyholders’ surplus.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

 

(Unaudited)

 

COMPANY OVERVIEW

 

EMC Insurance Group Inc., a 56.5 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance and reinsurance. Property and casualty insurance is the most significant segment, representing 82.3 percent of consolidated premiums earned during the first nine months of 2007. For purposes of this discussion, the term “Company” is used interchangeably to describe EMC Insurance Group Inc. (Parent Company only) and EMC Insurance Group Inc. and its subsidiaries. Employers Mutual and all of its subsidiaries (including the Company) and an affiliate are referred to as the “EMC Insurance Companies.”

 

The Company’s four property and casualty insurance subsidiaries and two subsidiaries and an affiliate of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the “pooling agreement”). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business, with the exception of any voluntary reinsurance business assumed from nonaffiliated insurance companies, and assumes from Employers Mutual an amount equal to its participation in the pool. All premiums, losses, settlement expenses and other underwriting and administrative expenses, excluding the voluntary reinsurance business assumed by Employers Mutual from nonaffiliated insurance companies, are prorated among the parties on the basis of participation in the pool. The aggregate participation of the Company’s property and casualty insurance subsidiaries in the pooling agreement is 30 percent. Employers Mutual negotiates reinsurance agreements that provide protection to the pool and each of its participants, including protection against losses arising from catastrophic events.

 

Operations of the pool give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the pool participants are not subject to the pooling agreement. The pooling agreement also provides that Employers Mutual will make up any shortfall or difference resulting from an error in its systems and/or computational processes that would otherwise result in the required restatement of the pool participants’ financial statements.

 

The purpose of the pooling agreement is to spread the risk of an exposure insured by any of the pool participants among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms, lines of insurance written, rate filings and commission plans offered by each of the companies.

 

The Company’s reinsurance subsidiary is a party to a quota share reinsurance retrocessional agreement with Employers Mutual (the “quota share agreement”). Under the terms of the quota share agreement, the reinsurance subsidiary assumes a 100 percent quota share portion of Employers Mutual’s assumed reinsurance business, exclusive of certain reinsurance contracts. This includes all premiums and related losses, settlement expenses, and other underwriting and administrative expenses of this business, subject to a $2,000,000 cap on losses assumed per event. The reinsurance subsidiary pays Employers Mutual a 10.5 percent premium charge as compensation for the $2,000,000 cap per event. The reinsurance subsidiary assumes all foreign currency exchange gains/losses associated with contracts incepting on January 1, 2006 and thereafter that are subject to the quota share agreement. Operations of the quota share agreement give rise to inter-company balances with Employers Mutual, which are settled on a quarterly basis. The investment and income tax activities of the reinsurance subsidiary are not subject to the quota share agreement.

 

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The reinsurance subsidiary does not directly reinsure any of the insurance business written by Employers Mutual or the other pool participants; however, Employers Mutual assumes reinsurance business from the Mutual Reinsurance Bureau (MRB) pool and this pool provides a small amount of reinsurance protection to the EMC Insurance Companies. As a result, the reinsurance subsidiary’s assumed exposures include a small portion of the EMC Insurance Companies’ direct business, after ceded reinsurance protections purchased by the MRB pool are applied. In addition, the reinsurance subsidiary does not reinsure any “involuntary” facility or pool business that Employers Mutual assumes pursuant to state law.

 

In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the interim financial statements have been included. The results of operations for the interim periods reported are not necessarily indicative of results to be expected for the year.

 

INDUSTRY OVERVIEW

 

An insurance company’s underwriting results reflect the profitability of its insurance operations, excluding investment income. Underwriting results are calculated by subtracting losses and expenses incurred from premiums earned. An underwriting profit indicates that a sufficient amount of premium income was received to cover the risks insured. An underwriting loss indicates that premium income was not adequate. The combined ratio is a measure utilized by insurance companies to gauge underwriting profitability and is calculated by dividing losses and expenses incurred by premiums earned. A number less than 100 generally indicates an underwriting gain; a number greater than 100 generally indicates an underwriting loss.

 

Insurance companies collect cash in the form of insurance premiums and pay out cash in the form of loss and settlement expense payments. Additional cash outflows occur through the payment of acquisition and underwriting costs such as commissions, premium taxes, salaries and general overhead. During the loss settlement period, which varies by line of business and by the circumstances surrounding each claim and may cover several years, insurance companies invest the cash premiums; thereby earning interest and dividend income. This investment income supplements underwriting results and contributes to net earnings.

 

Additional information regarding issues affecting the insurance industry is presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2006

Form 10-K.

 

MANAGEMENT ISSUES AND PERSPECTIVES

 

During the third quarter of 2007 management continued to focus its efforts on developing and implementing strategies to facilitate profitable growth in the increasingly competitive insurance marketplace, and establishing and maintaining adequate and consistent loss and settlement expense reserves. Management also reviewed its long-term strategies for Farm and City Insurance Company, which is a subsidiary in the property and casualty insurance segment that ceased writing direct nonstandard risk automobile insurance business in 2004, but continues to participate in the pooling agreement. As a result of this review, management has determined that there are no identified uses for this company and has therefore recommended the merger of Farm and City into one of the other property and casualty insurance segment’s subsidiaries, EMCASCO Insurance Company. In addition, management recently reviewed the statutory surplus position of each of the Company’s insurance subsidiaries and determined that the reinsurance subsidiary had sufficient surplus to allow the redemption of all $11,000,000 of surplus notes held by Employers Mutual. Following is a more detailed discussion of these issues. A discussion of other issues being addressed by management is presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2006 Form 10-K.

 

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Developing and implementing strategies to facilitate profitable growth

 

On an overall basis, rate competition continued to increase moderately in the property and casualty insurance marketplace during the first nine months of 2007, resulting in an approximate 4.8 percent decline in premium rate levels from September, 2006. Market conditions are expected to remain competitive during the remainder of 2007, which will likely result in a further decline in overall premium rate levels. As a result, top line growth will need to come from new business writings that are carefully selected and priced adequately, and continued efforts to maintain, or improve, policy retention. Personal lines growth is being generated primarily out of selected territories where it is believed the best profit potential exists. New policy counts trended upward through the first six months of 2007, but leveled off to 2006 levels during the third quarter. On a year-to-date basis, new policy counts increased 4.3 percent in commercial lines and 5.4 percent in personal lines. Retention levels continue to exceed industry averages and remain at approximately 87 percent for commercial lines and 86 percent for personal lines.

 

During the past several years management has developed and implemented several new sophisticated underwriting tools that have not only contributed to the Company’s improved underwriting results, but are expected to facilitate better control and stability of the Company’s underwriting results in the future. Many of these underwriting tools, which are more commonly referred to as predictive modeling capabilities and monitoring tools, were not available during the last soft market and are expected to play a prominent role in the Company’s efforts to manage its operating results during the current soft market.

 

The predictive modeling tools include insurance scoring in the personal lines of business and Underwriting Analysis Tools (UAT) in the commercial lines of business. The UAT allows the Company to segment its book of business based on future profit potential using proprietary predictive models that enable underwriters to make better informed decisions regarding acceptability and appropriate pricing for each individual risk. This information is available in real time to underwriters as they consider a new risk, or renew an existing risk.

 

Management has sophisticated systems in place to monitor its underwriting and pricing practices. These systems allow management to analyze data at a summary level or to drill down to a more detailed level, such as by individual underwriter or individual account. Management can also track the level of utilization of the various tools and monitor how those tools affect underwriting and pricing decisions. The Company’s Rate Comparison System provides underwriters with real-time information about the “true” rate level change for each commercial renewal account by eliminating differences in exposures, coverage, deductibles and/or classifications. The information is available for every renewal and the underwriter has discretion in how it is used; however, the system captures the data for all renewals regardless of how the underwriter processes the renewal.

 

Management is currently exploring the potential benefits of certain data mining software tools. Management believes such software could provide easily accessible, highly insightful summary information that is quickly constructed from the vast amounts of data contained in the Company’s claims system. Such information offers the potential of alerting management of conditions that have affected the Company’s underwriting results in nearly limitless levels of detail. Once alerted, management could act quickly to adjust underwriting practices and/or pricing to address those conditions and thereby mitigate developing adverse trends.

 

These enhanced capabilities are designed to enable management to (1) track the quality of the Company’s book of business at nearly any level of detail, (2) monitor changes in the quality of the Company’s book of business over time, (3) assure that pricing and underwriting decisions are consistent with profit objectives, and (4) develop action plans to address specific book quality and profitability concerns, and quantify the impact of executing those plans.

 

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Maintaining adequate and consistent loss and settlement expense reserves

 

The Company reported a significant amount of favorable development on prior years’ reserves during the first nine months of 2007, with the majority of the favorable development occurring in the property and casualty insurance segment. On a direct basis, approximately 61 percent of the favorable development came from case loss reserves and, in aggregate, all of this development is associated with the final settlement of closed claims. Approximately 25 percent of the favorable development came from incurred but not reported (IBNR) reserves, and was partially driven by a decline in IBNR emergence during this period. The remaining favorable development came from settlement expense reserves.

 

From management’s perspective, investors and potential investors should not place undo emphasis on the composition of the Company’s underwriting results (i.e. the breakdown between the amount of favorable development reported on prior years’ reserves versus the indicated current accident year results) because the Company’s reserving methodology does not lend itself to that type of analysis very well. Management believes that it is important for investors and potential investors to have an appropriate understanding of the Company’s reserving methodology so that they are able to properly interpret the Company’s results of operations and make informed investment decisions. Following is a brief discussion of the Company’s reserving methodology.

 

Management does not use accident year loss picks to establish the Company’s carried reserves. Case loss and IBNR reserves, as well as settlement expense reserves, are established independently of each other and added together to get the Company’s total loss and settlement expense reserve estimate.

 

At December 31, 2006, approximately 62 percent of the property and casualty insurance segment’s carried reserves were represented by case loss reserves, which are the individual reserves established for each reported claim based on the specific facts associated with each claim. Case loss reserves are based on the probable, or most likely, outcome for each claim, with probable outcome defined as what is most likely to be awarded if the case were to be decided by a civil court in the applicable venue or, in the case of a workers’ compensation case, by that state’s Worker’s Compensation Commission. On an individual claim basis, these case reserves represent the Company’s best estimate of exposure. However, when these individual case loss reserves are accumulated, the total is believed to be somewhat conservative because all claims will not be settled at the probable outcome amount.

 

The remaining 38 percent of the property and casualty insurance segment’s carried reserves were comprised of IBNR and settlement expense reserves, which are established through an actuarial process for each line of business. The IBNR and certain settlement expense reserves are allocated to the various accident years using historical claim emergence and settlement payment patterns; other settlement expense reserves are allocated to the various accident years on the basis of loss reserves.

 

The current and more recent accident years have a larger proportion of case, IBNR and settlement expense reserves than earlier accident years. Since the Company’s reserve levels are established somewhat conservatively, the relatively high proportion of reserves in the more recent accident years generates relatively high loss and settlement expense ratios in the early stages of an accident year’s development; however, as those accident years mature, claims are gradually settled, the reserves for those years become smaller, and the loss and settlement expense ratios generally decline.

 

Without a proper understanding of the Company’s reserving methodology, the current and more recent accident year combined ratios could be misinterpreted. For example, the Company reported a 94.9 percent combined ratio for the first nine months of 2007. If you add back the large amount of favorable development experienced on prior years’ reserves during this period, it would appear that the 2007 accident year is generating a combined ratio of 108.3 percent through the first nine months of the year, which, by the way, is down from 110.3 percent at the end of March, but up from 107.5 percent at the end of June. However, the Company’s current actuarial projections indicate that the 2007 accident year combined ratio will continue to decline as the accident year matures.

 

It is management’s intention to continue to apply this reserving methodology on a consistent basis. With reasonably consistent levels of reserve adequacy, management expects earnings from downward development of prior accident year reserves to continue in future years. For that reason, management believes that less emphasis should be placed on the composition of the Company’s underwriting results between current and prior accident years, and more emphasis should be placed on where the Company’s carried reserves fall within the range of actuarial indications.

 

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As part of ongoing efforts to enhance the effectiveness of the Company’s reserving process, the methodology now includes bulk case loss reserve adjustments. These bulk reserve adjustments will supplement the aggregate reserves of the individual claim files and will be used to help maintain a consistent level of overall case loss reserve adequacy. Bulk case loss reserve adjustments (both positive and negative) will be established when necessary to keep the estimated adequacy of the Company’s carried case loss reserves at a level consistent with management’s best estimate of the Company’s overall liability.

 

The Company’s actuarial department is currently in the process of evaluating the overall adequacy of the case loss reserves as of September 30, 2007. Based on the preliminary results of this review, it is anticipated that the methodology will produce an increase in overall case loss reserves in the fourth quarter of 2007.

 

Merger of Farm and City Insurance Company into EMCASCO Insurance Company

 

Farm and City Insurance Company was formed in Iowa in 1962 to write nonstandard risk automobile insurance and was purchased by the Company in 1984. Due to changes in the nonstandard risk automobile insurance marketplace, Farm and City stopped writing direct business and implemented non-renewal procedures on all existing business in 2004; however, Farm and City has continued to participate in the pooling agreement and currently receives 1.5 percent of all pool business. Management recently completed a review of the long-term strategies for Farm and City and determined that there are no identified uses for the company. Accordingly, management recommended the merger of Farm and City into one of the other property and casualty insurance segment’s subsidiaries, EMCASCO Insurance Company. This merger will result in Farm and City’s 1.5 percent pool participation percentage being assumed by EMCASCO Insurance Company and will increase EMCASCO Insurance Company’s pool participation percentage from 12 percent to 13.5 percent. The Company’s aggregate 30 percent pool participation percentage will not change. The goodwill currently carried on the Company’s financial statements stemming from the acquisition of Farm and City will not be impacted by the merger. This merger has been approved by the boards of directors of each company and the Iowa Insurance Division and is expected to be completed in the fourth quarter of 2007.

 

Proposed redemption of reinsurance subsidiary’s surplus notes

 

Management recently completed an evaluation of the statutory surplus position of each of the Company’s insurance subsidiaries. Based on this evaluation, management has determined that the reinsurance subsidiary has an adequate amount of surplus to support its current and proposed level of business and has recommended that the $11.0 million of surplus notes currently issued to Employers Mutual be redeemed in the fourth quarter. The $25.0 million of surplus notes issued by the property and casualty insurance subsidiaries and held by Employers Mutual will not be redeemed at this time; however, the current interest rate of 3.09 percent will be reviewed at an Inter-Company board committee meeting in February, 2008.

 

CRITICAL ACCOUNTING POLICIES

 

The accounting policies considered by management to be critically important in the preparation and understanding of the Company’s financial statements and related disclosures are presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Company’s 2006

Form 10-K.

 

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RESULTS OF OPERATIONS

 

Segment information and consolidated net income for the three months and nine months ended September 30, 2007 and 2006 are as follows:

 

 

(1) The allocation of incurred losses and settlement expenses between events associated with the current accident year and events associated with prior accident years for the three months ended September 30, 2006 reflect an adjustment in the factors utilized to allocate the direct IBNR reserve by accident year. For a detailed analysis of this issue, see the discussion under “Losses and settlement expenses – 2006 IBNR reserve accident year allocation factors.”

 

 

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(1) The allocation of incurred losses and settlement expenses between events associated with the current accident year and events associated with prior accident years for the three months ended September 30, 2006 reflect an adjustment in the factors utilized to allocate the property and casualty insurance segment’s direct IBNR reserve by accident year. For a detailed analysis of this issue, see the discussion under “Losses and settlement expenses – 2006 IBNR reserve accident year allocation factors.”

 

Net income was $6,728,000 ($0.49 per share) for the three months ended September 30, 2007 compared to $10,975,000 ($0.80 per share) for the same period in 2006. This decrease is attributed to a decline in underwriting results in both the property and casualty insurance segment and the reinsurance segment, but was partially offset by a decline in realized investment losses. For the nine months ended September 30, 2007, net income decreased to $35,420,000 ($2.57 per share) from $42,053,000 ($3.07 per share) for the same period in 2006. This decrease is attributed to a decline in the property and casualty insurance segment’s underwriting results and a decline in realized investment gains. The reinsurance segment reported an improvement in year-to-date underwriting results due to strong second quarter results.

 

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Premiums Earned

 

Premiums earned increased 1.7 percent and 0.7 percent to $96,815,000 and $290,820,000 for the three months and nine months ended September 30, 2007 from $95,150,000 and $288,860,000 for the same periods in 2006. The increase for the three months ended September 30, 2007 is attributed to both the reinsurance segment and the property and casualty insurance segment. The increase for the nine months ended September 30, 2007 is attributed to the property and casualty insurance segment, which was able to achieve a small increase in top line growth despite a continued decline in premium rates. On an overall basis, rate competition continued to increase moderately in the property and casualty insurance marketplace during the third quarter and management expects market conditions to remain competitive for the remainder of the year, assuming there are no significant market altering catastrophic events. Consequently, the Company’s overall rate level is expected to continue to decline moderately in the fourth quarter.

 

Premiums earned for the property and casualty insurance segment increased 0.8 percent and 0.9 percent to $80,452,000 and $239,459,000 for the three months and nine months ended September 30, 2007 from $79,793,000 and $237,431,000 for the same periods in 2006. Underlying these small increases in premium income is a continued decline in overall premium rate levels, which was more than offset by an increase in new business premium. Total policy count remained relatively flat during the first nine months of 2007, with the commercial lines of business, which generally carry a larger premium per policy, experiencing an increase in policy count and the personal lines experiencing a decline. The increase in the commercial lines policy count is attributed to recent initiatives targeted toward small businesses. Commercial lines new business premium was up 6.4 percent during the first nine months of 2007, while the retention rate increased slightly to 86.7 percent. In personal lines, management is continuing its efforts to increase premium production in geographic areas with profit potential and is focusing the efforts of the branch personnel in those territories. Personal lines new business premium was up 3.2 percent during the first nine months of 2007; however, this new business premium was not sufficient to offset the premium lost from declining rate levels and business not retained, resulting in a small decline in personal lines premium income. Retention rates increased slightly to 85.3 percent in personal property and 87.4 percent in personal auto.

 

Premiums earned for the reinsurance segment increased 6.6 percent to $16,363,000 for the three months ended September 30, 2007 from $15,357,000 for the same period in 2006, but declined 0.1 percent to $51,361,000 for the nine months ended September 30, 2007 from $51,429,000 for the same period in 2006. The increase for the three months ended September 30, 2007 is attributed to an increase in brokered reinsurance business. A decline in MRB premiums (which is associated with an account that was not renewed) is primarily responsible for the decline in premium income for the first nine months of 2007. Premium income for calendar year 2007 is currently projected to be approximately $68 million, which would represent a decline of approximately 7.0 percent from 2006.

 

Premium rates on reinsurance contract renewals have been primarily flat, and in some cases down slightly, during 2007. Premium rate increases that have been obtained have primarily been small and isolated to contracts with 2006 catastrophe losses and coastal accounts with Hurricane Katrina, Rita and Wilma losses. Recently, there have been indications of increasing rate competition in the reinsurance marketplace, which could result in lower rate levels during the January, 2008 renewal season.

 

Premiums written for the reinsurance segment increased $6,369,000, or 14.2 percent, in the first nine months of 2007; however, this increase reflects a negative $3,440,000 portfolio adjustment made in the first quarter of 2006 in connection with Employers Mutual’s reduced participation in the MRB pool. Excluding this adjustment, written premiums increased $2,929,000, or 6.1 percent, during the first nine months of 2007.

 

As previously reported, one of the members of the MRB pool has indicated that they will no longer participate in the pool effective January 1, 2008. Management of the pool has identified a potential replacement for this member and the MRB board of directors will be voting on this issue during the fourth quarter. If a replacement is not approved during the fourth quarter, Employers Mutual’s participation in the pool would increase to approximately 25 percent in 2008 from the current 20 percent.

 

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Losses and settlement expenses

 

2006 IBNR reserve accident year allocation factors

 

The allocation of incurred losses and settlement expenses between events associated with the current accident year and events associated with prior accident years for the three months ended September 30, 2006 reflect an adjustment in the factors utilized to allocate the property and casualty insurance segment’s direct IBNR reserve by accident year. Following is a detailed discussion of this issue.

 

An IBNR reserve is established at the end of each quarter for every line of business. For financial reporting purposes, this IBNR reserve is allocated to the various loss accident years using actuarially determined factors. In early 2006, after analyzing the accident year allocation of the IBNR reserve for several prior years, management noted that at the beginning of a new calendar year an insufficient amount of the IBNR reserve appeared to be allocated to prior accident years. In other words, the IBNR reserve allocated to the various accident years at the end of recent calendar years appeared to be released too quickly during the subsequent calendar year.

 

In an attempt to address this situation, management adjusted the IBNR reserve accident year allocation factors so that a larger portion of the March 31, 2006 and June 30, 2006 IBNR reserve was retained in prior accident years, with a correspondingly smaller amount allocated to the current accident year. The adjustment in the IBNR reserve accident year allocation factors was eliminated at September 30 and therefore did not have an impact on the amount of development reported for the nine months ended September 30, 2006. It is important to note that the adjustments made to the IBNR reserve accident year allocation factors did not impact net income reported for the three months or nine months ended September 30, 2006. The only impact of this change in accident year allocation factors is that the reported amount of favorable development experienced on prior years’ reserves was $10,752,000 less in the first quarter, and was $5,392,000 and $5,360,000 greater in the second and third quarters, respectively, than what would have been reported had the factors not been adjusted. Conversely, the current accident year results were $10,752,000 better in the first quarter, and $5,392,000 and $5,360,000 worse in the second and third quarters, respectively, than what would have been experienced had the factors not been adjusted, resulting in no affect on net income. The adjustments made to the 2006 accident year allocation factors were not effective, and were confusing to the readers of the Company’s financial statements. Therefore, management did not implement similar adjustments to the 2007 accident year allocation factors.

 

Following is a reconciliation of the development on prior years’ reserves for the property and casualty insurance segment from what would have been reported had the IBNR reserve accident year allocation factors not been adjusted, to the amount reported in the Company’s financial statements for the first, second and third quarters of 2006.

 

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Losses and settlement expenses

 

Losses and settlement expenses increased 15.6 percent and 6.1 percent to $64,536,000 and $174,426,000 for the three months and nine months ended September 30, 2007 from $55,839,000 and $164,369,000 for the same periods in 2006. The loss and settlement expense ratio increased to 66.7 percent and 60.0 percent for the three months and nine months ended September 30, 2007 from 58.7 percent and 56.9 percent for the same periods in 2006. The large increase in the ratio for the three months ended September 30, 2007 is attributed to both the property and casualty insurance segment and the reinsurance segment, while the increase in the ratio for the nine months ended September 30, 2007 is attributed to only the property and casualty insurance segment.

 

The loss and settlement expense ratio for the property and casualty insurance segment increased to 64.9 percent and 58.4 percent for the three months and nine months ended September 30, 2007 from 57.5 percent and 54.1 percent for the same periods in 2006. The increases in these ratios are primarily attributed to an increase in both large losses (greater than $250,000) and catastrophe and storm losses, as well as the moderate, but steady, decline in premium rate levels. An increase in claim frequency was mostly offset by a decline in claim severity. The increase in catastrophe and storm losses has been driven largely by losses associated with the Greensburg, Kansas tornado that occurred during the second quarter. Losses and settlement expenses from this event totaled $6,237,000 ($0.29 per share after tax), with $6,093,000 recognized during the second quarter. This event exhausted the annual aggregate deductibles on the pool’s reinsurance agreements for both individual (per risk) property losses and property catastrophe losses, thus future property losses that are incurred by the pool during the remainder of 2007 will be eligible for reinsurance recoveries. The steady decline in premium rate levels over the past two years has resulted in an approximate 2.5 percentage point increase in the loss and settlement expense ratio for the first nine months of 2007.

 

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The loss and settlement expense ratio for the reinsurance segment increased to 75.4 percent for the three months ended September 30, 2007 from 64.7 percent for the same period of 2006, but declined to 67.2 percent from 69.7 percent for the nine months ended September 30, 2007. The ratio for the three months ended September 30, 2007 reflects an increase in the IBNR reserve, a significant decline in the amount of favorable development experienced on prior years’ reserves, and an increase in catastrophe and storm losses. The adjustment to the IBNR reserves was implemented to maintain a consistent level of reserve adequacy. For the nine months ended September 30, 2007, the ratio improved primarily due to an increase in the amount of favorable development experienced on prior years’ reserves.

 

Acquisition and other expenses

 

Acquisition and other expenses increased 1.8 percent and 1.2 percent to $34,576,000 and $101,565,000 for the three months and nine months ended September 30, 2007 from $33,968,000 and $100,362,000 for the same periods in 2006. The acquisition expense ratio remained constant at 35.7 percent for the three months ended September 30, 2007 and 2006, and increased slightly to 34.9 percent for the nine months ended September 30, 2007 from 34.7 percent for the same period in 2006.

 

For the property and casualty insurance segment, the acquisition expense ratio decreased to 37.5 percent for the three months ended September 30, 2007 from 38.0 percent for the same period in 2006, but remained fairly constant at 37.4 percent for the nine months ended September 30, 2007 compared to 37.3 percent for the same period in 2006. The decrease in the ratio for the three months ended September 30, 2007 was primarily driven by a decline in policyholder dividends, but was partially offset by an increase in contingent commission expense associated with the agents’ profit share plan. For the nine months ended September 30, 2007 an increase in contingent commission expense was more than offset by a decline in hurricane related assessments (Mississippi Windstorm Underwriting Association assessments for Hurricane Katrina in the second quarter of 2006). Hurricane related assessments are recoverable from reinsurers and are included as a reduction of losses (reflected in the loss and settlement expense ratio).

 

For the reinsurance segment, the acquisition expense ratio increased to 26.6 percent and 23.3 percent for the three months and nine months ended September 30, 2007 from 24.1 percent and 23.1 percent for the same periods in 2006. The increases in these ratios are primarily due to higher commission expenses. The increase in the ratio for the nine months ended September 30, 2007 also reflects Employers Mutual’s reduced participation in the MRB pool in 2006. In connection with this change in pool participation, the reinsurance subsidiary recognized $1,343,000 of commission income in the first quarter of 2006 as reimbursement for expenses previously incurred to generate the reinsurance business that was transferred to the new assuming members on January 1, 2006. This commission income was partially offset by $688,000 of deferred policy acquisition costs that were amortized to expense as a result of the change in pool participation.

 

Investment results

 

Net investment income increased 5.2 percent and 3.2 percent to $12,252,000 and $35,895,000 for the three months and nine months ended September 30, 2007 from $11,641,000 and $34,788,000 for the same periods in 2006. These increases are primarily attributed to higher average invested asset balances and a small increase in the yield on fixed maturity securities.

 

The Company reported net realized investment losses of $281,000 and $1,022,000 for the three months ended September 30, 2007 and 2006, and net realized investment gains of $1,232,000 and $3,011,000 for the nine months ended September 30, 2007 and 2006, respectively. The Company recognized “other-than-temporary” investment impairment losses totaling $689,000 and $1,073,000 during the three months and nine months ended September 30, 2007 compared to $681,000 and $726,000 for the same periods in 2006. These impairment losses were recognized because management determined that it was likely that these securities, which were in an unrealized loss position, would be sold before they recovered to their cost basis. As a result, the intent to hold these securities to recovery did not exist.

 

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Other expense

 

The increase in other expense for both the three months and the nine months ended September 30, 2007 over the same periods of 2006 is due to $298,000 of foreign currency exchange losses recognized during the third quarter of 2007 by the reinsurance subsidiary on its contracts with foreign reassureds.

 

Income tax

 

Income tax expense decreased 52.7 percent and 20.7 percent to $2,059,000 and $14,231,000 for the three months and nine months ended September 30, 2007 from $4,354,000 and $17,940,000 for the same periods in 2006. The effective tax rate for the three months and nine months ended September 30, 2007 was 23.4 percent and 28.7 percent, compared to 28.4 percent and 29.9 percent for the same periods in 2006. The fluctuations in the effective tax rates reflect the changes in pre-tax income earned during these periods relative to the amount of tax-exempt interest income earned.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Liquidity

 

Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet cash obligations. The Company had positive cash flows from operations of $6,160,000 and $8,831,000 during the first nine months of 2007 and 2006, respectively. The Company typically generates substantial positive cash flows from operations because cash from premium payments is generally received in advance of cash payments made to settle claims. These positive cash flows provide the foundation of the Company’s asset/liability management program and are the primary drivers of the Company’s liquidity. When investing funds made available from operations, the Company invests in securities with maturities that approximate the anticipated payments of losses and settlement expenses of the underlying insurance policies. In addition, the Company maintains a portion of its investment portfolio in relatively short-term and highly liquid assets as a secondary source of liquidity should net cash flows from operating activities prove inadequate to fund current operating needs. As of September 30, 2007, the Company did not have any significant variations between the maturity dates of its investments and the expected payments of its loss and settlement expense reserves.

 

The Company is a holding company whose principal asset is its investment in its insurance subsidiaries. As a holding company, the Company is dependent upon cash dividends from its insurance company subsidiaries to meet all obligations, including cash dividends to stockholders. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. The maximum amount of dividends that the insurance company subsidiaries can pay to the Company in 2007 without prior regulatory approval is approximately $57,702,000. The Company received $3,625,000 and $6,755,000 of dividends from its insurance company subsidiaries and paid cash dividends to its stockholders totaling $7,019,000 and $6,583,000 in the first nine months of 2007 and 2006, respectively.

 

The Company’s insurance company subsidiaries must have adequate liquidity to ensure that their cash obligations are met; however, because of their participation in the pooling agreement and the quota share agreement, they do not have the daily liquidity concerns normally associated with an insurance or reinsurance company. This is due to the fact that under the terms of the pooling and quota share agreements, Employers Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and the assumed reinsurance business ceded to the Company’s reinsurance subsidiary, and then settles the inter-company balances generated by these transactions with the participating companies within 45 days after the end of each quarter.

 

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At the insurance company subsidiary level, the primary sources of cash are premium income, investment income and maturing investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt, and investment purchases. Cash outflows can be variable because of uncertainties regarding settlement dates for unpaid losses and because of the potential for large losses, either individually or in the aggregate. Accordingly, the insurance company subsidiaries maintain investment and reinsurance programs generally intended to provide adequate funds to pay claims without forced sales of investments. In addition, Employers Mutual has a line of credit available to provide additional liquidity if needed. The insurance company subsidiaries have access to this line of credit through Employers Mutual.

 

The Company maintains a portion of its investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to pay claims and expenses. At September 30, 2007, approximately 56 percent of the Company’s fixed maturity securities were in U.S. government or U.S. government-sponsored agency securities. A variety of maturities are maintained in the Company’s portfolio to assure adequate liquidity. The maturity structure of the fixed maturity securities is also established by the relative attractiveness of yields on short, intermediate and long-term securities. The Company does not invest in high-yield, non-investment grade debt securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.

 

The Company considers itself to be a long-term investor and generally purchases fixed maturity securities with the intent to hold them to maturity. Despite this intent, the Company currently classifies purchases of fixed maturity securities as available-for-sale to provide flexibility in the management of its investment portfolio. The Company had net unrealized holding gains, net of deferred taxes, on fixed maturity securities available-for-sale totaling $7,669,000 and $6,319,000 at September 30, 2007 and December 31, 2006, respectively. The fluctuation in the market value of these investments is primarily due to changes in the interest rate environment during this time period. Since the Company does not actively trade in the bond market, such fluctuations in the fair value of these investments are not expected to have a material impact on the operations of the Company, as forced liquidations of investments is not anticipated. The Company closely monitors the bond market and makes appropriate adjustments in its portfolio as conditions warrant.

 

The majority of the Company’s assets are invested in fixed maturity securities. These investments provide a substantial amount of investment income that supplements underwriting results and contributes to net earnings. As these investments mature, or are called, the proceeds are reinvested at current rates, which may be higher or lower than those now being earned; therefore, more or less investment income may be available to contribute to net earnings depending on the interest rate level.

 

The Company participates in a securities lending program administered by Mellon Bank, N.A. whereby certain fixed maturity securities from the investment portfolio are loaned to other institutions for short periods of time. The Company receives a fee for each security loaned out under this program and requires initial collateral, primarily cash, equal to 102 percent of the market value of the loaned securities. The cash collateral that secures the Company’s loaned securities is invested in a Delaware business trust that is managed by Mellon Bank. The earnings from this trust are used, in part, to pay the fee the Company receives for each security loaned under the program.

 

The Company held $111,000 and $552,000 in minority ownership interests in limited partnerships and limited liability companies at September 30, 2007 and December 31, 2006, respectively. The Company does not hold any other unregistered securities.

 

The Company’s cash balance was $181,000 and $196,000 at September 30, 2007 and December 31, 2006, respectively.

 

During the first nine months of 2007, Employers Mutual contributed $3,300,000 to the postretirement plans’ VEBA trusts, but did not make any contributions to the pension plans. In 2007, Employers Mutual expects to make contributions totaling $3,500,000 to the pension plans and $4,172,000 to the VEBA trusts. The Company reimbursed Employers Mutual $941,000 for its share of the contribution to the VEBA trusts.

 

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During the first nine months of 2006, Employers Mutual did not make a contribution to the pension plans and made a $4,200,000 contribution to the VEBA trusts. During the fourth quarter of 2006, Employers Mutual contributed $27,596,000 to the pension plans and $900,000 to the VEBA trusts. The Company reimbursed Employers Mutual $8,410,000 for its share of the pension contribution in 2006 (no reimbursement was paid in the first nine months of 2006) and $1,455,000 for its share of the VEBA trusts contribution in 2006 (includes $1,198,000 during the first nine months 2006).

 

Capital Resources

 

Capital resources consist of stockholders’ equity and debt, representing funds deployed or available to be deployed to support business operations. For the Company’s insurance subsidiaries, capital resources are required to support premium writings. Regulatory guidelines suggest that the ratio of a property and casualty insurer’s annual net premiums written to its statutory surplus should not exceed three to one. On an annualized basis, all of the Company’s insurance subsidiaries were well under this guideline at September 30, 2007.

 

The Company’s insurance subsidiaries are required to maintain a certain minimum level of surplus on a statutory basis, and are subject to regulations under which the payment of dividends from statutory surplus is restricted and may require prior approval of their domiciliary insurance regulatory authorities. The Company’s insurance subsidiaries are also subject to Risk Based Capital (RBC) requirements that may further impact their ability to pay dividends. RBC requirements attempt to measure minimum statutory capital needs based upon the risks in a company’s mix of products and investment portfolio. At December 31, 2006, the Company’s insurance subsidiaries had total adjusted statutory capital of $310,280,000, which was well in excess of the minimum RBC requirement of $52,753,000.

 

The Company had total cash and invested assets with a carrying value of $1.0 billion as of September 30, 2007 and December 31, 2006. The following table summarizes the Company’s cash and invested assets as of the dates indicated:

 

 

 

 

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The amortized cost and estimated fair value of fixed maturity and equity securities at September 30, 2007 were as follows:

 

 

 

 

The Company’s property and casualty insurance and reinsurance subsidiaries have issued surplus notes to Employers Mutual amounting to $25 million and $11 million, respectively. These surplus notes have an annual interest rate of 3.09 percent and do not have a maturity date. Payment of interest and repayment of principal can only be made out of the applicable subsidiary’s statutory surplus and is subject to prior approval by the insurance commissioner of the respective state of domicile. The surplus notes are subordinate and junior in right of payment to all obligations or liabilities of the applicable insurance subsidiaries. The Company’s subsidiaries incurred interest expense of $834,000 in the first nine months of 2007 and 2006 on these surplus notes. The Company’s reinsurance subsidiary plans to redeem all $11 million of its outstanding surplus notes, plus accrued interest, during the fourth quarter.

 

As of September 30, 2007, the Company had no material commitments for capital expenditures.

 

Off-Balance Sheet Arrangements

 

Employers Mutual receives all premiums and pays all losses and expenses associated with the assumed reinsurance business ceded to the reinsurance subsidiary and the insurance business produced by the pool participants, and then settles the inter-company balances generated by these transactions with the participating companies on a quarterly basis. When settling the inter-company balances, Employers Mutual provides the reinsurance subsidiary and the pool participants with full credit for the premiums written during the quarter and retains all receivable amounts. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by Employers Mutual and the expense is charged to the reinsurance subsidiary or allocated to the pool members on the basis of pool participation. As a result, the Company has an off-balance sheet arrangement with an unconsolidated entity that results in a credit-risk exposure that is not reflected in the Company’s financial statements. Based on historical data, this credit-risk exposure is not considered to be material to the Company’s results of operations or financial position.

 

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Investment Impairments and Considerations

 

The Company recorded $1,073,000 of “other-than-temporary” investment impairment losses in the first nine months of 2007 on twelve equity securities (includes $689,000 of impairment losses during the three months ended September 30, 2007 on five equity securities). These impairment losses were recognized because management determined that it was likely that these securities, which were in an unrealized loss position, would be sold before they recovered to their cost basis. As a result, the intent to hold these securities to recovery did not exist. The Company recorded $726,000 of “other-than-temporary” investment impairment losses during the first nine months of 2006 on eleven equity securities (includes $681,000 of impairment losses during the three months ended September 30, 2006 on ten equity securities).

 

The Company has no direct exposure to sub-prime residential lending, holding only $1,469,000 of residential mortgage-backed securities, all of which are seasoned Government National Mortgage Association thirty year fixed maturity securities. No residential collateralized debt obligations or collateralized mortgage obligations are held.

 

The Company does have indirect exposure to sub-prime residential lending markets as it has significant holdings of government agency securities, as well as fixed maturity and equity securities in both the banking and financial services sectors. While these holdings do not include companies engaged in originating residential lending as their primary business, it does include companies that may be indirectly engaged in this type of lending. However, none of these securities have been considered for other-than-temporary impairment at this time.

 

At September 30, 2007, the Company had unrealized losses on held-to-maturity and available-for-sale securities as presented in the table below. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services. None of these securities are considered to be in concentrations by either security type or industry. The Company uses several factors to determine whether the carrying value of an individual security has been “other-than-temporarily” impaired. Such factors include, but are not limited to, the security’s value and performance in the context of the overall markets, length of time and extent the security’s fair value has been below carrying value, key corporate events and collateralization of fixed maturity securities. Based on these factors, and the Company’s ability and intent to hold the securities until recovery or maturity, it was determined that the carrying value of these securities was not “other-than-temporarily” impaired at September 30, 2007. Risks and uncertainties inherent in the methodology utilized in this evaluation process include interest rate risk, equity price risk, and the overall performance of the economy, all of which have the potential to adversely affect the value of the Company’s investments. Should a determination be made at some point in the future that these unrealized losses are “other-than-temporary”, the Company’s earnings would be reduced by approximately $1,707,000, net of tax; however, the Company’s financial position would not be affected due to the fact that unrealized losses on available-for-sale securities are reflected in the Company’s financial statements as a component of stockholders’ equity, net of deferred taxes.

 

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            Following is a schedule of the length of time securities have continuously been in an unrealized loss position as of September 30, 2007.

 

 

 

All non-investment grade fixed maturity securities held at September 30, 2007 (Great Lakes Chemical Corporation and US Freightways Corporation) were in an unrealized gain position. The Company does not purchase non-investment grade securities. Any non-investment grade securities held by the Company are the result of rating downgrades that occurred subsequent to their purchase.

 

The Company recognized $1,882,000 of gross realized losses in the first nine months of 2007. The gross realized losses included $809,000 from the sale of equity securities and $1,073,000 of “other-than-temporary” investment impairment losses on twelve equity securities. Gross realized losses totaling $1,768,000 were associated with securities that were in an unrealized loss position for three months or less and $114,000 came from securities that were in an unrealized loss position for over three months to six months. No realized losses were recognized on fixed maturity securities.

 

LEASES, COMMITMENTS AND CONTINGENT LIABILITIES

 

The following table reflects the Company’s contractual obligations as of September 30, 2007. Included in the table are the estimated payments that the Company expects to make in the settlement of its loss reserves and with respect to its long-term debt. One of the Company’s property and casualty insurance subsidiaries leases office facilities in Bismarck, North Dakota with lease terms expiring in 2014. Employers Mutual has entered into various leases for branch and service office facilities with lease terms expiring through 2017. All lease costs are included as expenses under the pooling agreement, after allocation of the portion of these expenses to the subsidiaries that do not participate in the pooling agreement. The table reflects the Company’s current 30.0 percent aggregate participation in the pooling agreement. The Company’s contractual obligation for long-term debt did not change from that presented in the Company’s 2006 Form 10-K.

 

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The participants in the pooling agreement are subject to guaranty fund assessments by states in which they write business. Guaranty fund assessments are used by states to pay policyholder liabilities of insolvent insurers domiciled in that state. Many states allow assessments to be recovered through premium tax offsets. Estimated guaranty fund assessments of $1,595,000 and $1,451,000 and related premium tax offsets of $1,120,000 and $929,000 have been accrued as of September 30, 2007 and December 31, 2006, respectively. The guaranty fund assessments are expected to be paid over the next two years and the premium tax offsets are expected to be realized within ten years of the payments. The participants in the pooling agreement are also subject to second-injury fund assessments which are designed to encourage employers to employ a worker with a pre-existing disability. Estimated second-injury fund assessments of $1,588,000 and $1,769,000 have been accrued as of September 30, 2007 and December 31, 2006, respectively. The second injury fund assessment accruals are based on projected loss payments. The periods over which the assessments will be paid is not known.

 

The participants in the pooling agreement have purchased annuities from life insurance companies, under which the claimant is payee, to fund future payments that are fixed pursuant to specific claim settlement provisions. The Company’s share of loss reserves eliminated by the purchase of these annuities was $1,779,000 at December 31, 2006. The Company has a contingent liability of $1,779,000 should the issuers of these annuities fail to perform under the terms of the annuity. All of the issuing companies maintain strong financial ratings, therefore, the Company believes the likelihood of failure of any of the issuing companies is remote. The Company’s share of the amount due from any one life insurance company does not equal or exceed one percent of its subsidiaries’ aggregate policyholders’ surplus.

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NEW ACCOUNTING PRONOUNCEMENTS

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments” – an Amendment of FASB Statement Nos. 133 and 140. SFAS 155 simplifies the accounting for certain hybrid financial instruments by permitting fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and eliminates a restriction on passive derivative instruments that a qualifying special-purpose entity may hold. The Company adopted SFAS 155 effective January 1, 2007. Adoption of this statement had no effect on the operating results of the Company.

 

In June 2006, the FASB issued Interpretation (FIN) No. 48 “Accounting for Uncertainty in Income Taxes” to clarify the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS 109 “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance for de-recognition of tax positions, financial statement classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Company adopted FIN 48 effective January 1, 2007. Adoption of FIN 48 had no effect on the operating results of the Company, as an assessment of the Company’s current tax positions indicated no uncertainties that would warrant different recognition and valuation from that applied in the Company’s tax returns.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating what impact, if any, this statement will have on its financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS 159 permits reporting entities to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. As it relates to the Company’s financial reporting, the Company would be permitted to elect fair value recognition of fixed maturity and equity investments currently classified as either available-for-sale or held-to-maturity, and report the unrealized gains and losses from these investments in earnings going forward. Electing the fair value option for an existing held-to-maturity security will not call into question the intent of an entity to hold other fixed maturity securities to maturity in the future. The provisions of this statement are effective beginning with the first fiscal year that begins after November 15, 2007. The Company is currently evaluating the alternatives permitted by this statement and the impact those alternatives would have on its financial statements.

 

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

 

The Private Securities Litigation Reform Act of 1995 provides issuers the opportunity to make cautionary statements regarding forward-looking statements. Accordingly, any forward-looking statement contained in this report is based on management’s current beliefs, assumptions and expectations of the Company’s future performance, taking into account all information currently available to management. These beliefs, assumptions and expectations can change as the result of many possible events or factors, not all of which are known to management. If a change occurs, the Company’s business, financial condition, liquidity, results of operations, plans and objectives may vary materially from those expressed in the forward-looking statements. The risks and uncertainties that may affect the actual results of the Company include, but are not limited to, the following: catastrophic events and the occurrence of significant severe weather conditions; the adequacy of loss and settlement expense reserves; state and federal legislation and regulations; changes in our industry, interest rates or the performance of financial markets and the general economy; rating agency actions and other risks and uncertainties inherent to the Company’s business. When the Company uses the words “believe”, “expect”, “anticipate”, “estimate” or similar expressions, the Company intends to identify forward-looking statements. Undue reliance should not be placed on these forward-looking statements.

 

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ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The main objectives in managing the investment portfolios of the Company are to maximize after-tax investment return while minimizing credit risks, in order to provide maximum support for the underwriting operations. Investment strategies are developed based upon many factors including underwriting results, regulatory requirements, fluctuations in interest rates and consideration of other market risks. Investment decisions are centrally managed by investment professionals and are supervised by the investment committees of the respective boards of directors for each of the Company’s subsidiaries.

 

Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks of the financial instruments of the Company relate to the investment portfolio, which exposes the Company to interest rate and equity price risk and, to a lesser extent, credit quality and prepayment risk. Monitoring systems and analytical tools are in place to assess each of these elements of market risk.

 

Two categories of influences on market risk exist as it relates to financial instruments. First are systematic aspects, which relate to the investing environment and are out of the control of the investment manager. Second are non-systematic aspects, which relate to the construction of the investment portfolio through investment policies and decisions, and are under the direct control of the investment manager. The Company is committed to controlling non-systematic risk through sound investment policies and diversification.

 

Further analysis of the components of the Company’s market risk (including interest rate risk, equity price risk, credit quality risk, and prepayment risk) can be found in the Company’s 2006 Form 10-K.

 

 

The Company, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Securities Exchange Act) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely making known to them material information relating to the Company and the Company’s consolidated subsidiaries required to be disclosed in the Company’s reports filed or submitted under the Exchange Act.

 

There were no changes in the Company’s internal control over financial reporting that occurred during the first nine months of 2007 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

 

 

 

The following table sets forth information regarding purchases of equity securities by the Company and affiliated purchasers for the three months ended September 30, 2007:

 

 

 

(1) 103, 93 and 1,500 shares were purchased in the open market during July, August and September, respectively, under the Company’s dividend reinvestment and common stock purchase plan. 8,013 shares were purchased in the open market during July under Employers Mutual Casualty Company’s employee stock purchase plan.

 

(2) On May 12, 2005 the Company announced that its parent company, Employers Mutual Casualty Company, had initiated a $15 million stock purchase program under which Employers Mutual would purchase shares of the Company’s common stock in the open market. This purchase program was effective immediately and does not have an expiration date.

 

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38

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

 

 

 

 

Date: November 8, 2007

 

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EMC INSURANCE GROUP INC. AND SUBSIDIARIES

 

INDEX TO EXHIBITS

 

 

 

 

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